Dear Reader,

Welcome to the weekend edition of Casey’s Daily Dispatch, a compilation of our favorite stories from the week for the time-stressed readers.

Of course, if you want to read all of the Daily Dispatches from the week, you may do so in the archives at

After the Brick and Mortar Funeral, What’s Next?

By Vedran Vuk

The brick-and-mortar video stores such as Blockbuster, Hollywood Video, and Movie Gallery are on their way out. Blockbuster has been beaten down to penny stock status at 14 cents per share. On the other hand, Netflix has a roaring share price of $139.

Though Netflix appears to be a very attractive business, I see cracks in its future. No, I’m not recommending Blockbuster’s stock. The company has serious problems and will be gone soon enough. Though I wouldn’t be surprised to see it emerge out of bankruptcy as an online-only business. But Netflix’s model isn’t perfect either. Would I short them? No, not yet, but maybe down the road.

For now, the company should still perform well as it aims the kill-shot at the brick-and-mortar stores. But once the competition is dead, what’s next?

In my opinion, too many investors are watching Netflix’s success. After the brick-and-mortar stores exit the picture, new competitors will arise. And that’s where the problem comes in. Though Netflix has an innovative business model, it is also an extremely replicable model.

Traditional brick-and-mortar stores can always differentiate through location. A restaurant downtown will make more money than the same chain in the middle of nowhere. With prime locations, business can overcharge to gain an edge. But with the Internet, there’s no location. Everyone stands on a level playing field. Hence, price becomes the primary competitive tool. When competition occurs through price, margins are naturally squeezed. No one can overcharge based on location or convenience when another competitor is only a click away.

To avoid this, websites create reasons for the customer to remain loyal. Amazon and especially eBay have done this particularly well. On the websites, one receives ratings based on transactions with other customers. The more smooth transactions you perform, the more other buyers and sellers trust you. Hence, the longer one uses the site, the better the interaction. If the customer left for another website, reputational benefit would be lost.

Further, networking effects are important too – and I don’t mean the social kind. A networking effect is an economic term for value that increases with the number of users. For example, suppose someone constructed a website identical to Facebook. Would it be worth as much as Facebook? Of course not. Facebook’s value comes from the millions of users utilizing the site rather than from the actual software behind it. Similarly, Amazon and eBay wouldn’t be particularly useful with only a handful of sellers. Replicating the networking effect presents a greater challenge than actually copying the business model.

Netflix lacks this key component. There’s no advantage to more subscribers. Sure, the company will have more movies with increased revenues, but this is a matter of inventory. If Walmart increases its customer base, it, too, has more inventory. This is not a networking effect but rather an economy-of-scale issue. Second, Netflix subscribers have no reason to stay on the site. If someone offered a better price or service, the customer would be gone. These missing foundations will be a problem in the long run.

As Netflix continues to succeed, the sharks will begin to circle. A few companies have made lackluster efforts to emulate Netflix. So far, they’ve failed to put a significant dent in Netflix. However, eventually a bigger competitor will emerge and take a chunk of the company’s market share. This could take a while, but it’s coming. In the next ten years, I wouldn’t be at all surprised to see several major competitors. The company will face lower margins and less market share. Perhaps, when the first serious contender arrives on the scene, I’ll be ready to short Netflix.

Foreign Buyers of Our Government Debt Are Changing

By Bud Conrad

The U.S. continues its delicate balance of buying foreign goods that supply the money to foreigners to buy our government debt. They now own $4 trillion of Treasuries, having purchased a half-trillion in the last year. That supplies our federal government to fund our $1.5 trillion budget deficit. Without these big purchases by foreigners, our interest rates would have to rise to attract buyers and the dollar would be weaker.

The chart below shows foreigners’ holdings of our government debt (Treasuries) over the last year. While the upward slope seems modest in this big-picture view, that is because they started the year with $3.5 trillion Treasuries. The 16% growth is large.

The breakout between Foreign Private and Foreign Official shows that the private sector is the source of growth. Remember that across this time frame, many had been losing confidence in the eurozone after Greece became close to insolvent. That caused a flight toward the dollar, and the safest dollar investment is Treasuries.

A further breakdown to the largest holders reveals one important shift: China actually sold off holdings. This is a surprise, as their trade surplus with us continued in positive territory. Hong Kong bought $45 B in this period, so the total sell-off would be less if this was added to mainland China’s $72 B sell-off.

The other surprise is the size of the purchases from the U.K. Some of this could be from Britain-based people and enterprises fearing problems with their pound, but more likely it comes from other countries that use the money center of London to make their investments, so we see it as Britain-based. The most likely would be Middle Eastern oil interests, as oil prices are higher and the investments are shielded from the direct linkage back to the source. It could also be other Europeans using London to transact on their behalf, fleeing the euro for the perceived safety of the dollar.

Japan has returned to buying U.S. Treasuries, perhaps because their own interest rates are so low.

While the overall picture shows foreigners continuing to invest in Treasuries, there is some weakness in the components here. The one to watch is China as they hold $843 B, and if they sold in quantity, we could face serious problems in the U.S. with funding our budget deficits.

The other question is what is behind the big purchases from the U.K. and whether they are potentially fickle if, say, U.S. policy in the Middle East were to bring caution to investors in dollars. There isn’t enough data here to predict the future, but the sheer size of the foreign holding adds danger to those that think we can run deficits forever without consequences.

So I watch this data closely as a way to read foreigners’ confidence. The relatively modest Chinese sell-off should be watched closely, because if it grew, other countries could lose confidence too.

You’ll Buy Gold Now and Like It!

By Jeff Clark, Casey’s Gold & Resource Report

I get this question a lot: “Should I buy gold now, or wait for a pullback?”

It’s a valid question. For nearly two years, gold hasn’t had a serious decline. There have been pullbacks, of course, but nothing assumption-challenging. In fact, since October 2008, gold’s largest price drop is 10.6% (based on London PM fix prices), and yet the average of all declines since 2001 is 13% (of those greater than 5%). The biggest pullback we’ve seen this summer is 8.2%. Technically the summer’s not over, but I’ll admit I’m surprised we haven’t had a better buying opportunity.

So, is now the time to buy? It depends on your honest answer to another question: “Do you own enough gold?” By “enough” I mean an amount that lends meaningful protection on your assets. By ”meaningful” I mean that no matter what happens next – another financial blow-up, accelerating inflation, crushing deflation, war, a plummeting dollar, more reckless government spending – you won’t worry about your investments.

Whether you should buy now is almost irrelevant if you don’t already own a meaningful amount of gold. If you earn $50,000 a year, how is one gold Eagle coin going to protect you if the dollar plummets and sends inflation soaring? If your investable assets total $100,000, is your nest egg sufficiently protected owning two gold Maple Leafs? This is all akin to buying a $50,000 insurance policy for a $500,000 home.

Today we face the prospect of prolonged economic stagnation, and most governments are administering grossly abusive monetary policy as a remedy. While some of the consequences are already being felt, the full ramifications have not hit your wallet yet. But they will.

If you don’t have at least 10% of your investable assets in physical gold, or at least two months of living expenses, you have your answer: Buy. Don’t use leverage, don’t borrow money, and don’t buy with reckless abandon, but yes, get your asset insurance policy and tuck it away. And then start working toward 20% (we recommend a third of assets be in various forms of gold in Casey’s Gold & Resource Report).

Back to the original question: should we buy now, or wait for a pullback?

The answer comes when you look at the big picture. If you pull up a 9-year chart of gold, what sticks out is that the price is near its all-time nominal high. One could be forgiven for thinking it looks toppy or at least ripe for a pullback. But I assert that the highs for gold have yet to be charted.

What will a gold chart look like after adding five years to it?

When projecting gold’s potential price peak, there are many ways to measure it. Conservatively, gold reaching its inflation-adjusted 1980 high would have it topping around $2,400 an ounce. More radically, if the U.S. tried to cover its cumulative foreign trade deficit with its current gold holdings, gold would need to hit about $32,000/oz.

Let’s take something more middle of the road, and apply the same trough-to-peak percentage advance gold underwent in the 1970s. (I think there’s a greater than 50/50 chance it does more than that, given the precarious nature of the U.S. dollar.) Gold rose from $35 in 1970 to $850 in 1980, a factor of 24.28. Our price bottomed in 2001 at $255.95; multiply that by 24.28 and you get a gold price of $6,214 per ounce.

Sound too high? Well, would it feel high if you had to pay $12.50 for a Big Mac? At $3.39 today at my local McDonald’s, that’s about what it would cost ten years from now if we get the same rate of inflation we had in the late 1970s.

So if gold hits $6,214, what might it look like on a chart if you bought today around $1,200?

$1,200 doesn’t seem so pricey, does it?

I’m not saying there won’t be pullbacks or that you shouldn’t try to buy at lower prices. Just keep a big-picture perspective. Let’s say gold falls to $1,100 and you’re kicking yourself for having bought at $1,200… if gold reaches $6,200 an ounce, the profit difference between buying at $1,200 and buying at $1,100 is only 1.6%. If gold gets whacked to $1,000 (at which point I’ll be buying with both hands) the difference is still only 3.2%.

Heck, even if gold peaks at $2,400, you still get a double from current levels. (But unless government monetary policies immediately reverse course, gold isn’t stopping at $2,400.)

So there’s my answer. Yes, you have to accept my projection of gold’s ultimate price plateau. And you have to sell at some point to realize the profit. But if the final chapter of this bull market looks anything like the chart above, I don’t think you’ll be too upset having bought at $1,200.

Carpe gold.

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The (Dis)Service Economy

By Kevin Brekke, Editor
Casey Research, Switzerland

Employment is back in the news. Actually, the news remains all about employment or the lack thereof. The number of those newly jobless and filing for unemployment benefits scooted higher for the third consecutive week, reaching the half-million mark once again.

Not only is the level of new claims alarming, an unwelcome trend looks to be developing and gathering a head of steam, as shown in the following chart. For all of 2010, new weekly claims have been stuck in a range, where for the first half of the year they were in a zig-zag down trend that has since reversed course. Stated another way, and pandering to our readers that use technical analysis (we are TA skeptics), you might say that the initial claims number is set to break through the upper boundary of a trend channel.

Curiously, note the grayed area of the chart indicting a period of recession. This data is taken from the St. Louis Federal Reserve website, and they have apparently declared that the recession that commenced in 4Q 2007 ended 2Q 2010. The NBER, the official recession-dating arbiter, has yet to declare the recession’s demise. We declare that one of them is right.

Recession or not, a recovery we can believe in will require job growth. Sustained, long-term job growth. Other indicators, however, show that businesses are decidedly agnostic about the stamina of any claimed “recovery.”

From yesterday’s BLS release:

    “Over the year (July 2009 to July 2010), real average hourly earnings rose 0.4 percent, seasonally adjusted. An increase in average weekly hours of 1.2 percent combined with the increase in real average hourly earnings resulted in a 1.6-percent increase in real average weekly earnings during this period.”

Translation: fewer employees are working longer hours.

And therein lies the rub. A paltry 1.6% increase in the earnings of the employed will not offset the total loss of earnings by the nation’s unemployed. The service-based economy and its reliance on consumption has always been a dual-blade razor. We are now suffering the nicks and cuts from the other side of the blade as falling consumption reinforces itself in a negative feedback loop. Only when imbalances are purged from the system will equilibrium attain and the free market be allowed to dictate investment and demand.

Leading up to our current state of disrepair were decades of misallocated capital directed into the budding-turned-Kudzu service economy to cater to all those shoppers. We again face the dull blade of consequence.

Returning again to the BLS:

    “In May 2009, the 10 occupations with the highest employment levels represented more than 20 percent of total employment, and the number of workers in these occupations ranged from 1.9 million workers to 4.2 million workers.

    “Most of these occupations were relatively low paying: 9 of the 10 largest occupations had median wages between $8.28 per hour and $14.56 per hour. Median wages for all occupations in the United States were $15.95 per hour in May 2009. The one exception among the 10 largest occupations was registered nurses, whose median wages were $30.65 per hour. Employment among registered nurses was 2.6 million in May 2009.”

The much-touted service economy has taken us to the point where nearly 1 in 5 employed Americans work in low-skilled, low-wage jobs. The singular exception being registered nurses, and we suspect that the new Obama health care bill will remedy that in no time.

Here are America’s 10 largest occupations by numbers employed. This report was recently released by the BLS, yet is current only through May ’09. However, there is little doubt that not much has changed.

So, the question should not be “Are we in a recovery?”

We need to be asking “What are we recovering to?”

Welcome to the dis-service economy.

And that, dear reader, is that for this week. Until next week, thank you for reading and for subscribing to a Casey Research service!

Chris Wood
Casey Research, LLC